The growth of crude-by-rail and pipeline capacity over the next few years should help boost Western Canadian crude prices and improve oil sands producers’ margins.

Canada's government on Tuesday approved Enbridge's (NYSE:ENB) proposed Northern Gateway pipeline that would ship heavy crude oil from Alberta's oil sands to Canada's West Coast, from where it could be exported to Asia.

If the pipeline crosses additional hurdles and is approved for construction, it should be an incremental positive for Canadian oil sands producers, who have suffered in recent years due to extremely depressed prices for Western Canadian crude.

Photo credit: Wikimedia Commons

Northern Gateway's promise Northern Gateway would be able to ship some 525,000 barrels per day of diluted bitumen -- a thick, viscous type of heavy crude oil -- from Alberta's oil sands. With Canadian oil production expected to more than double to 4.1 million barrels a day by 2025 from 2013 levels, demand for capacity on Northern Gateway is likely to be extremely strong.

While many oil sands producers have been making do by shipping their output via rail, pipelines such as Northern Gateway and TransCanada's(NYSE:TRP) Keystone XL will provide substantial additional takeaway capacity from the oil sands, serving to diversify the transportation mix and bring Western Canadian heavy crude prices in line with other Northern American crude benchmarks.

Over the past five years, Western Canadian Select (WCS) -- the benchmark for Western Canadian heavy crude oil -- has traded at a steep five-year average discount of nearly $20 a barrel relative to the main U.S. oil benchmark. According to Chevron, this wide price gap is costing Canada's oil sands industry about C$18 billion a year.

Oil sands producers' woes As a result, oil sands' profitability is significantly lower than conventional oil operations as measured by operating netbacks -- defined as a company's oil and gas sales, less royalties and operating expenses, averaged over the company's per barrel of oil equivalent production.

Take Husky Energy, for instance. During the first quarter, the company generated an operating netback of $35.99 per barrel for its oil sands operations, as compared to $52.75 per barrel for its conventional medium oil operations and $41.86 per barrel for conventional heavy oil.

Similarly, operating netbacks for large oil sands producers like Canadian Natural Resources(NYSE:CNQ) and Cenovus Energy(NYSE:CVE) are significantly lower than those of light-oil-focused peers, such as Crescent Point Energy and Lightstream Resources.

Canadian Natural's operating netback came in at $34.61 per barrel during the first quarter, while Cenovus reported a netback of $44.41 per barrel in the same period. By contrast, Crescent Point Energy and Lightstream Resources' netbacks came in at $52.65 and $56.11 per barrel, respectively.

Pipelines could reduce price gap While the Northern Gateway pipeline can't boost oil sands producers' profitability on its own, the combination of Keystone XL, Northern Gateway, and an expansion of Kinder Morgan Energy Partners' (NYSE:KMP) Trans Mountain Pipeline should help bring Canadian heavy crude prices in line with other North American benchmarks by easing existing supply bottlenecks.

Keystone, for instance, could ship as much as 830,000 barrels of Canadian crude per day to refiners along the US Gulf Coast, while Kinder Morgan's expanded Trans Mountain Pipeline would provide 890,000 barrels per day of capacity from Alberta to Vancouver, British Columbia. If all three proposed pipeline projects are approved, constructed, and brought into service, they would boost takeaway capacity by more than 2 million barrels per day.

Still, it remains unclear whether these projects will be completed. A decision on Keystone has been delayed by the Obama administration, while Enbridge still faces a number of hurdles before it can begin construction on the proposed C$6.5 billion ($6 billion) Northern Gateway pipeline. It will have to satisfy 209 conditions proposed by Canada's National Energy Board and overcome intense opposition from environmentalists, Aboriginal groups and local communities.

Investor takeaway The combination of new pipeline projects and rapid growth in crude by rail bode well for the future of Canada's oil sands. If pipeline projects like Northern Gateway and Keystone are approved, built, and placed into service, they should help significantly boost Canadian heavy crude prices, thereby improving oil sands producers' margins and operating netbacks.

Author

Arjun is a value-oriented investor focusing primarily on the oil and gas sector, with an emphasis on E&Ps and integrated majors. He also occasionally writes about the US housing market and China’s economy.